INTM516080 - Thin capitalisation: practical guidance: interest cover - debt servicing: measuring cash flow sufficiency to pay interest and repay capital

There are several ways to test the sufficiency of cash flow of a company to service its debts. These are suggested as possibilities only, since cash flow covenants are not regularly used in the Advance Thin Capitalisation Agreement (ATCA) process. Possible approaches are as follows:

Method 1 - adjust the EBITDA of the borrowing unit to arrive at cash flow

  • Deduct from EBITDA - capital expenditure, debt repayments, increases in working capital, tax paid, dividends paid, acquisitions, share capital redemptions, non-cash revenue (credits) and released provisions.
  • Add to EBITDA - new debt drawn, reductions in working capital, dividends received, proceeds of share issues, insurance payouts, non-cash expenses (debits) and provision increases.

There should be, as a minimum, a surplus which is sufficient to cover the expected interest payments and scheduled debt repayments. The ratio of surplus cash to interest plus debt repayments should also be sufficient to cover other expenses not already accounted for, for example if the company has a policy of paying dividends then the cash flow availability should include funds to meet the anticipated level of payments.

Method 2 - work from a cash flow statement prepared for the borrowing unit

  • identify the net operating cash flow from the Consolidated Cash Flow Statement. This figure is typically the figure for operating profit per the Consolidated Profit and Loss Account adjusted for changes in non cash transactions, for example, depreciation, amortisation, and changes in working capital.

A covenant for cash flow cover for the total of interest charged and all debt repayments may then be agreed.

Where there is bullet debt (repayable in full at end of the term), a notional annual figure may be included, probably on a straight line annual repayment basis.

The ratio should be greater than 1:1 on the basis that there will be other calls on cash flow, for example, to pay dividends.

A variation would be to account for debt withdrawals and repayments, capital expenditure and asset sale proceeds within the cash flow exercise, and frame the covenant in terms of the interest charge alone. If all capital items have been caught in the above, the covenant may be in terms of net cash flow to interest charged.

The ratio chosen would need to leave sufficient cash available to fund the future of the business and provide a return for shareholders.

Such a covenant may be in addition to an EBITDA-linked covenant, as is frequently seen in arm’s length bank agreements.